Usa Subprime Mortgage Financial Crisis

1.0 Introduction

The USA subprime mortgage financial had a great impact on many countries around the world in 2007. The main cause of the subprime crisis was financial instruments like securitisation where banks would pool their loans into assets, which were sold to investors, thus passing risky loans to investors (Shah, 2010). This created a liquidity shortfall in the US banking system as the assets decreased in value, and consequently led to the collapse of large financial institutions. Stock markets around the world fell and governments had to bail out their financial systems.

The monetary policies had to be reviewed in order to restore stability in financial markets and to prevent further losses. Monetary policy can be defined as the actions of the central banks that aim to influence the interest rates in order to maintain inflation within a target range (usually between 2% and 3%) and thus achieve the economic objectives of the country (textbook p. 423). Different regions adopted different monetary policies based on their specific economic conditions - inflation, its level of production or its level of employment - and also based on the central bank's objectives in terms of price stability, employment and growth (Rocheteau & Tinlin, 2007).

In USA, the monetary policies are controlled by the US Federal Reserve Bank (Fed) while in Europe it is controlled by the European Central Bank (ECB). Both regions adopted different monetary policies, which will be discussed in this report.

2.0 The Financial Crisis

The financial crisis can be divided into four specific periods as shown in the diagram below. Firstly, the period of financial turmoil, from August 2007 till September 2008, where short-term money market rates started to increase drastically (Stark, 2009). Second was the intensification of the financial crisis following the bankruptcy of Lehman Brothers in September 2008 during which the major economies of the world suffered a major deterioration (Stark, 2009). The third period was the period of temporary financial improvements in financial market conditions in 2009 where the financial markets started to stabilise (ECB report). The final period is the sovereign debt crisis in 2010.

(ECB Report, 2010)

Throughout the different periods, different monetary policies had to be adopted to achieve the objectives of the Fed - full employment and price stability (Rosengren, 2009) - and that of the European Central Bank that is to maintain price stability. In USA, the global crisis caused the unemployment rate to increase up to 8.5% in three months, i.e. approximately 1.8 million jobs. Governments have to influence the monetary policies so as to achieve economic prosperity.

2.1 Period of financial turmoil

Severe tensions emerged between the interbank markets worldwide during the period of financial turmoil. As a result, overnight rates shot up. This in shown in Figure 5 below where the spread between the London Inter-Bank Borrow Rate (LIBOR) shows the sudden increase of overnight rates. Central banks had to supply large quantity of reserves in response to the increase in demand of banks (Cecchetti, 2008).

(Cecchetti, 2008)

Both the ECB and the Fed used overnight repurchase agreements to inject money in their respective banking systems. The ECB responded immediately by allowing banks to draw full amount of liquidity needed on an overnight basis: a sum of €95 billion of liquidity was drawn by banks, indicating the gravity of the situation (ECB report). The next day, €61 billion was used to renew the operation. The Fed used one-day repurchase agreement to inject $24 billion in the U.S. banking system and this amount reached $38 billion on the next day.

The ECB conducted additional refinancing procedures with maturities of three to six months to encourage banks to continue providing credit in the economy. Operations were also carried out to maintain the short-term market rates close to the ECB's refinancing rate, as shown below. Also, the ECB provided US dollar liquidity based on the swap agreement with the Federal Reserve Bank. To maintain its objective of price stability, the ECB increased its key interest rate to 4.25% in July 2008 (shown by the pointed arrow in the diagram below).

(ECB report)

Similarly, the Fed also decreased its interest rates to about 4%. It also encouraged banks to continue the market activity by acting as a secured source of liquidity. This was done through the Term Auction Facility where the Fed holds auctions of fixed amounts of term credit to banks regularly (Kohn, 2009). Like the ECB, the Fed established swap lines with foreign central banks in late 2007, enabling them to obtain dollars such that they can meet the dollar liquidity needs of the banks (as shown below). However, contrary to the ECB, the Fed extended liquidity facilities borrowers and investors.

2.2 Intensification of financial crisis

The bankruptcy of Lehman Brothers in the U.S. marked the second phase of the financial crisis when markets strains went from serious to calamitous (Poole, 2009). It shook the global market and led to a great drop in the U.S. stock market. Economic conditions around the world worsened and central banks had to modify their monetary policies.

Consistent with its objective of maintaining price stability and because of the rapidly declining inflationary pressures, the ECB had to lower its interest rate to 1.00% on its main refinancing operations between October 2008 and May 2009 (as seen above in Chart 4) (Stark, 2009). In the U.S., the Fed decreased its funds rate to almost zero by the end of 2008 as shown in the diagram below.

After the fall of Lehman Brothers, the Fed lowered interest rates drastically - between zero and 0.25% - to conserve